A Crummey Trust is one of several strategies for accumulating and protecting funds that are to be dedicated to a child’s education. None of these methods is superior to the others, but they have unique features that appeal to parents in different circumstances.
In previous posts, we covered the following strategies: Qualified Tuition Plans (529 Plans), Coverdell Education Savings Accounts, UTMA/UGMA accounts, and gifts of specific assets such as Gifts of S Corporations, Gifts of Limited Liability Company interests, Gifts of family partnership interests, and Gifts to a Qualified Personal Residence Trust.
Another way for parents to accumulate funds for a college education while minimizing taxes is a Crummey Trust. These trusts allow parents to transfer assets to a child while taking advantage of the annual gift tax exclusion. It’s most helpful in cases in which the value of assets is large and the complete distribution of them to a student by age 21 is undesirable.
The annual gift tax exclusion, which is $16,000 per individual and $32,000 per married couple, can be applied in a Crummey Trust because a gift of assets to the trust is always accompanied by a withdrawal power that gives the beneficiary the right to withdraw the gift immediately, although there is an expectation that the beneficiary will not exercise this right. If the beneficiary does not exercise the withdrawal right, the gift-giver is still entitled to the annual gift tax exclusion and the gift remains in the trust.
A Crummey power can be included in another type of trust such as a Life Insurance Trust by means of a Crummey provision. A Crummey provision works as follows: The grantor makes a gift to the trust and, at the same time, the beneficiary is notified that they have the power to withdraw the gift. The simultaneous acts of the grantor giving a gift to the trust and the beneficiary being permitted to withdraw the gift immediately is construed as being the same as an outright gift. Thus, a gift to a trust with a Crummey provision also qualifies for the annual gift tax exclusion.
Income Tax Considerations
Until a Crummey power is exercised or allowed to lapse, the beneficiary is treated as the owner of any income derived from gifts (assets) put into the trust. If the beneficiary allows the Crummey power to lapse, but retains an interest in trust assets, as is often the case, the beneficiary will continue to be treated as the owner of the portion of the trust that their interest represents, and he or she will be taxed accordingly.
To the extent that Crummey Trust income is taxed to a beneficiary who is under the age of 18 or a student aged 19 to 23, the Kiddie Tax rules apply. To minimize the effect of income taxes, assets can be invested in non-income-producing securities such as growth stocks.
Crummey Trust vs. Sec. 2503(c) Trust
Parents often prefer a Crummey Trust over what’s referred to as a Sec. 2503(c) trust.
A Sec. 2503(c) trust, or minor’s trust, is established to hold gifts for a single child until he or she reaches age 21. A gift to this type of trust qualifies for the annual gift tax exclusion.
A Sec. 2503(c) trust can have only one beneficiary, and the assets in the trust are irrevocably his or hers. Because the trust is irrevocable, the grantor gives up total control of the assets. A Sec. 2503(c) trust pays taxes on its income. The beneficiary is only taxed when the trust makes distributions to him or her.
The trust allows all of the principal and income to be used for the child’s education until he or she reaches the age of 21. The IRS imposes a 10% penalty on those trusts that do not distribute all of it by age 21.
Parents often prefer a Crummey Trust because it is revocable and it gives them more control of the termination of the trust. Assets in a Sec. 2503(c) trust must be distributed when the child reaches age 21. This rule does not apply to a Crummey Trust or provision, which can extend to age 30.
Present Interest in a Crummey Trust
Normally, gifts to minors are under parental control until the child is 18 years old. In order to delay the transfer of control beyond age 18, the assets must be in a trust. However, the annual exclusion from the gift tax is only available for gifts of so-called present interest. A present interest is one that can be exercised now, that is, the interest holder can possess, use, encumber, or transfer the gift immediately. A gift that doesn’t come under the control of the beneficiary until the future is not a present interest.
A Crummey Trust achieves its desired effect by offering the beneficiary a window of time to take control of the gift, usually 30 days. This opportunity only applies to this year’s gift. If the beneficiary fails to exercise the right to withdraw the gift during the window of time, the gift becomes part of the trust. Since the beneficiary had the opportunity to receive the gift outside of the trust, the gift is deemed to be a present interest whether they actually did receive the gift or not. This is what entitles parents using a Crummey Trust to use the annual gift tax exclusion.
The expectation of giving future annual gifts or of withholding future gifts if the beneficiary opts to exercise control of a gift usually motivates the beneficiary to decline taking control of it. Some trusts explicitly state that the beneficiary’s exercise of control will result in “no further financial gifts made” to the trust in future years.
A Crummey Trust affects a family’s income, estate, and gift taxes. Careful consideration should be given to earnings potential and tax ramifications before setting one up.